Profits

Different types of profit

Profit Maximisation

Effects of changes in revenues and costs

The functions of profit in a market economy

Perspectives on profit

“What is a man if he is not a thief who openly charges as much as he can for the goods he sells?”

Gandhi

“Civilization and profits go hand in hand”

Calvin Coolidge

Economists have different profit concepts

Different types of profit

Profit measures the return to risk when committing scarce resources to a market or industry

Normal profit - is the minimum level of profit required to keep the factors of production in their current use in the long run

Normal profits reflect the opportunity cost of using funds to finance a business

Sub-normal profit - is any profit less than normal profit (where price < average total cost)

Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit

Numerical example

Price Per Unit

(£)

Demand / Output(units)

Total Revenue

(£)

Marginal Revenue

(£)

Total Cost(£)

Marginal Cost(£)

Profit(£)

50 33 1650 2000 -350

48 39 1872 37 2120 20 -248

46 45 2070 33 2222 17 -152

44 51 2244 29 2312 15 -68

42 57 2394 25 2384 12 10

40 63 2520 21 2444 10 76

38 69 2622 17 2480 6 142

36 75 2700 13 2534 9 166

34 81 2754 9 2612 13 142

32 87 2784 5 2720 18 64

30 93 2790 1 2870 25 -80

Accounting Profit & Economic Profit Accounting Profit

The difference between total revenue and costs incurred in the production of goods and services

Economic Profit

Takes into consideration the opportunity cost of resources used in funding production

E.g. £5 million pounds spent in producing an output might have generated a alternative rate of return had it been invested in financial markets.

Profit Maximisation Rule

Output

Price & Cost

AR=MR

MCMR>MC

Profits increasing

Profit Maximisation Rule

Output

Price & Cost

AR=MR

MCMR>MC

Profits increasing

MR<MC

Profits decreasing

Showing Total Profits

Output

Price & Cost

AR=MR

MCMR=MC

Maximum Profits

P1

AC

Q1

AC1

Showing Total Profits

Output

Price & Cost

AR=MR

MCMR=MC

Maximum Profits

P1

AC

Q1

AC1

Profit maximisation and an increase in demand

Output

Price &

Cost

MR

P1

AC

Q1

AC

MC

AR

Output

Price &

Cost

MR

P1

AC

Q1

AC

MC

ARMR2

AR2

P2

Profit maximisation

Output

Price & Cost

AR

MC

AC

MR

P1

AC

Q1

Profit maximisation following a shift in demand

Output

AR1

MC

AC

MR1

P1

AC

Q1

AR2

MR2

Q2

P2

AC2

Significance of profits

In a market based system profits influence the allocation of resources:

(1) Finance for investment: Retained profits remain the most important source of finance for capital investment

(2) Market entry: Rising profits send signals to other producers within a market

Supernormal profits – market entry

Subnormal profits – pressure for market exit

Demand for factor resources: Resources flow where the expected rate of return is highest

Route maps to higher profits Grow the business – achieve higher sales

Margins: High gross profit margin - every extra sale is highly profitable

Economies of scale: As a business grows, unit costs reduced through economies of scale.

Consumer loyalty and replacement demand - the value of each new customer lays not just in the immediate sale, but in future sales as well

Defending a high market share against competitors is easier than defending high profit margins

But close control of costs is also important